Stablecoins are called such because they are pegged to a fiat currency. If the peg is maintained, the stablecoin is as stable as the fiat currency, since it is always exchangeable with the fiat at a 1:1 ratio. But do you know what the keyword in that whole sentence is?
I believe what gives a stable coin true stability is not just the strength of the fiat currency it is pegged to, but also the way that it is pegged.
To define stability, let’s first define instability. The worst-case scenario for any financial institution taking deposits from retail investors is what is called a “bank run”. This happens when a large number of depositors (or a few depositors with a lot of funds) want to withdraw the money all at the same time, but the bank doesn’t have enough to satisfy all requests.
When it becomes clear to the rest of the depositors that the bank doesn’t have enough funds, and they may not get their money back, it sparks off a bank run. Panic sets in and almost ALL depositors rush to withdraw their money before the bank runs out of it.
If the bank always has enough money to satisfy all withdrawal requests, even if they all came at once, then I would consider this bank super stable.
Thus, the stability of a stablecoin has to be measured from 2 dimensions. One is the stability of the fiat currency it is pegged to. Imagine if there had been (or maybe there is, but I don’t know about it) a stablecoin pegged to the Sri Lankan Rupee. What would have happened to buyers of that stablecoin when the Rupee went through a major devaluation in March 2022?
Secondly, we have to look at the way it is pegged, and how strong that peg is. I shall analyze how each of the 3 major USD stablecoins, namely UST, USDT and USDC, maintain their peg.
The UST was pegged to the US Dollar at a 1:1 ratio, but that was based on what is called an “algorithmic peg”. It depends on market dynamics. When UST depreciates against the USD, arbitrage traders would (theoretically) quickly buy it, exchange it for Luna, and then use Luna to exchange for 1 USD in fiat.
Theoretically, there’s nothing wrong. The problem was that Terra, the company behind UST and Luna, held most of its reserves not in USD, but in crypto assets, primarily Bitcoin (BTC). When BTC devalued by more than 1/3 from its peak of more than USD 60,000 to less than USD 40,000, the value of Terra’s reserves also fell a lot. Right before the attack, there was USD 18.5 billion of UST in circulation but backed by only USD 3.2 billion of reserves held by the Luna Foundation Guard (LFG).
When the attack happened, a whale dumped USD 350 million worth of UST on the market. Arbitragers got spooked and didn’t enter the market to soak it up, and instead also started selling, putting further downward pressure on the UST.
This wouldn’t have been a problem if LGF, which was created to defend the UST against attacks, had more than enough reserves to quickly intervene, soak up all the UST that was being sold, and restore confidence in the currency. However, they simply didn’t have enough and spent more than 90% of their reserves in their failed defence of the UST before they ultimately abandoned it.
For those who don’t know how the attack unfolded, or don’t know how UST’s algorithm works, you can Google it. There’s a lot of information out there.
So is USDT, backed by Tether a better choice? Yes and no.
Yes because unlike Terra, which uses cryptocurrencies as its reserves, Tether uses assets denominated in USD as its reserves. Therefore, Tether’s reserves won’t fluctuate against the USD due to exchange rate fluctuations.
Also, USDT’s market capitalization is 4x higher than UST. Therefore, an attacker will probably need at least 4x more funds to trigger a bank run and force it to depeg.
Furthermore, USDT is (supposedly) 100% backed by reserves. So Tether is (theoretically) capable of defending the USDT against speculative attacks.
However, USDT has other problems.
Firstly, there’s a question mark whether Tether as a company is trustworthy. They were fined by the US government in Oct 2021 for misstating its reserves. They had made claims that their stablecoins were fully backed by cash reserves, which were found to be untrue.
Also, their auditor is a relatively unknown firm in the Cayman Islands. Why the Cayman Islands, when there are so many sizeable and reputable auditors in the USA? It’s not as though Tether can’t afford their services. So there’s been a lot of speculation that Tether’s reserves are overstated.
Secondly, even if it is fully backed as they claim, the composition of those reserves is a problem. The snapshot below is taken from their 31 March 2022 independent (supposedly) auditor’s report.
As you can see, not all of the reserves are held as cash. Cash and Bank deposits are only USD 4.1 billion, comprising a mere 5% of total reserves. Money market funds, US Treasury Bills and Reverse Repurchase Agreements, though not totally liquid, are still quite liquid and can be redeemed within days without loss of value. The total value of these “safe” assets (i.e. relatively liquid with little or no risk of devaluation) is about USD 50 billion, or only about 60% of total reserves.
Non-US Treasury Bills are liquid, but there’s a devaluation risk if the US dollar appreciates against these currencies. Fund and Precious Metals also risk devaluation as they fluctuate in value, even though it’s possible that they appreciate as well. Other Investments also include other digital tokens, and I wonder whether the valuation of these investments is still fair given the slide in crypto markets over the past few months?
Lastly, we come to Commercial Paper, comprising about 25% of the reserves, which is my big beef with Tether. In fact, it used to be 50% before they got sued by the US government and were forced to have better governance due to public scrutiny. These are basically unsecured business loans, with tenure of between 0 to 365 days. That means that they are NOT LIQUID.
If a run on USDT takes place, Tether will need to use its reserves to buy up USDT and take them out of circulation. But what happens if the run is big enough, and Tether’s reserves are depleted until they are left with nothing but the last 25% of commercial paper? How will they raise the cash needed to pay the depositors?
This is money that has already been given out as loans to businesses, and Tether cannot recall them before the due date. Tether will be faced with a liquidity squeeze, and will be forced to do a fire sale of these securities at a huge discount in order to raise cash.
So to me, USDT is a time bomb. They may have survived the initial run triggered by the UST crash (people lost confidence in stablecoins) by spending about USD 10 billion of its reserves to defend its peg. But will they be able to defend it again if there’s a real, concerted attack by a consortium of whales? At this point in time, there’s a lot of fear in the crypto market, and confidence in stablecoins is at an all-time low. If I was such a whale, I will launch this attack as soon as possible.
USDC is the only USD stable coin that I have some trust in.
Firstly, every time a USDC is minted, a US dollar of fiat currency has to be deposited into a US-regulated financial institution. Every time a USDC is redeemed (or “burned”), a US dollar of fiat currency is withdrawn from the account. Therefore, the number of USDC in circulation is ALWAYS exactly equal to the number of US Dollars sitting in these bank accounts, down to the LAST dollar, as you can see from their auditor’s April 2022 report screenshot below.
Thus, it is ALWAYS 100% fully backed by fiat reserves.
Secondly, all reserves are in US Dollars, and not in some other cryptocurrency, precious metals, foreign currency or other investments that may fluctuate in value against the US Dollar. There is ZERO risk of devaluation.
Thirdly, the reserves are fully liquid. So USDC will never have a liquidity squeeze, like what may happen to USDT if its reserves are depleted beyond 25%.
Fourthly, its auditor is Grant Thornton LLP, which is the 6th largest accounting firm in the USA with about 59 offices across the US and about 8,500 employees. They are not going to put their reputation on the line with some questionable accounting practices (like not marking the assets to market prices).
Last but not least, USDC is an open-source project. That means no individual person or company has total control over it. Therefore, there is little counter-party risk.
UST has already crashed, and there’s a real risk that USDT will follow. If you really still want to park your funds in a US stablecoin, the best (perhaps only) option now is USDC.